Putting Greek lessons into practice

Published in Business Spectator (Melbourne), 23 June 2011

Greece is a tiny country with enormous debt. But there are many more, and far larger, countries with similar problems. The hurly-burly of the crisis in Athens with its endless talk about haircuts, debt restructuring and austerity measures should not make us forget for a second that Greek debt is only a symptom of something much bigger.

Unfortunately, with the shifting focus on acute problems (Portugal yesterday, Greece today, maybe Belgium tomorrow?) we are missing the debt wood for the trees.

Sovereign debt problems are not exclusive to small countries on the periphery of Europe. On the contrary, and with very few exceptions, excessive public debt plagues most developed economies. The triple-A ratings still enjoyed by countries such as the US, the UK or Germany may signal temporary safety but they cannot deflect from serious long-term debt challenges.

It is not just the absolute debt figures that are frighteningly high but also the aggravations that result from demographic change. As populations age and sometimes even shrink, their ability to handle massive debt burdens in the future is dwindling. Japan, Italy and Germany are the first countries that will experience such a demographically induced debt shock.

At the same time, it is clear that there is little chance to solve the public debt problem through economic growth. The global debt situation after World War II was also dramatic but at the time a reconstruction boom across many Western nations helped to drive down debt to moderate levels. In contrast, there is no such boom in sight for the old West now, which is struggling to keep pace with competition from Asia and South America. The West can no longer hope to grow out of its debt.

In many ways, heavily indebted developed economies are entering uncharted territory. The debt mountains they are facing are systemic. That is to say they are not the result of wars or natural disasters but of chronic government overspending, not least on debt interest. In contrast to previous debt burdens that were contained and fused by economic expansion, many countries will need to deal with their debt problems in adverse economic and demographic circumstances.

What we are currently witnessing in Greece is a prelude to what most of the developed world can expect to experience at some stage over the coming decades. In Athens we see a government in its death throes, unable to finance its ongoing commitments to teachers, policemen, pensioners or, indeed, creditors. But unlike in Greece today, there will be no International Monetary Fund or European Union ready to help in future debt instances.

Countries like Italy, Japan or the US are not just too big to fail. They are also too big to be saved. Besides, today’s solvent saviours may well need to be saved themselves in the future.

All of this begs the question, what can be done about the developed countries’ debt levels before they reach a Greece-like financial abyss? The fact that politicians and central bankers are relatively mute on these fundamental issues suggests that they are either unaware of the problem or that they simply do not have any answers to it.

The number of options for coping with the developed world’s mountains of debt is limited. In my mind, there are precisely three ways the West could deal with its public debt.

First, countries could try to muddle through the crisis until mathematic certainties catch up with them so that they will eventually default. Second, governments could attempt to rid themselves of their obligations through printing money and inducing inflation. Third, as long as debt levels are not yet catastrophic, attempts could be made to lower them substantially, even if that requires some unusual measures.

It is quite clear which of the three strategies are currently dominant in indebted countries around the globe. Politicians have so far chosen the easiest options. They are muddling through their debt challenges like the Obama administration that is demonstrably lacking the will to rein in public spending. Or they are hoping that inflation will ease their debt woes like in Britain where real interest rates are now negative and inflation is close to 5 per cent.

Though both strategies may indeed appear to work for some time, their long-term consequences are usually disastrous. Muddling through does not solve any problems but edges a country closer to an eventual default; and relying on inflation is playing with economic fire and may not even work if creditors demand higher interest rates. Clearly, neither an eventual uncontrolled default nor a period of high inflation seem particularly good ideas for dealing with public debt.

This leaves the third option, namely to reduce debt levels substantially while it is still possible. The problem with this strategy is that debt is already at a level where a few spending cuts or tax increases do not suffice anymore. If Germany, for example, today started repaying €1 billion of government debt per month, it would take until the year 2177 until it was debt free again.

Another way of cutting debt is therefore required. One idea was recently proposed by Professor Otto Gassner, a lawyer and public finance expert based in Munich. He calculated for the German example that a moderate one-off tax on wealth could be used to pay off all government debt within a decade.

Among other measures, Gassner proposes ‘compulsory mortgages’ on real estate as part of a debt elimination package. Such mortgages had been used before, namely in the two German monetary reforms of 1923 and 1948. However, in the historic examples they followed hyperinflations after a sovereign default. In the present scenario, however, they would be used precisely to avert the chaos that results from such monetary breakdown.

A similar strategy might also work in the US. There government debt has reached the astronomical level of more than $US14 trillion, or just below the entire annual economic output. However, US households’ net worth is still several times higher. According to Federal Reserve data, it stands at $US53.5 trillion.

Of course, debt elimination strategies based on wealth taxes are not a liberal economist’s dream. But in the context of today’s government debt levels they could be seen as the least of three evils. The alternatives ‘uncontrolled default’ and ‘hyperinflation’ are hardly more enticing than a tax.

Besides, from a free market economist’s perspective the prospect of eliminating government debt once and for all would have a pleasant side effect. The funds previously needed for debt interest could be used to lower tax rates. In the UK, for example, this would be enough to cut income taxes by a quarter or VAT by half.

In this way, the long-term growth effects could at least partially outweigh the pain of the one-off tax on wealth. Debt elimination could then restore some of the economic freedom that has been eroded in big spending, big taxing modern welfare states.

The social unrest in the streets of Athens palpably demonstrates the dangers of letting public debt problems come to the boil. The developed world should watch them carefully and wonder what it can do to avoid a replay of such scenes in New York, London or Tokyo. Though there are no pain free solutions to the world’s public debt problems, this should not stop us from creatively exploring the options.